Avoiding Ponzi Schemes

It’s a safe bet there are a number of Ponzi schemes operating right now. Ponzi schemes are actually a lot more common than you might think and are often offered to retirees and other investors who are seeking higher income. Retirees are especially vulnerable to Ponzi schemes that offer the appearance of consistent high interest or dividends because so many retirees are trying to make ends meet.

Over the years I have seen a local real estate developer (whom everyone loved for his charity work in the community) borrow money to fund his developments by selling promissory notes secured by first trust deeds on real estate. After a while it was discovered that he had sold notes secured by the first position on the same property to dozens of different people and the developer just pocketed the difference.

I have seen real life schemes similar to The Producers where non-existent films and Broadway stage productions were funded. I have seen millions of dollars raised for non-existent new drugs and non-existent gold mines and oil wells. I have seen investors shocked when the young entrepreneur who was building a new business took their money and moved away.

A more typical Ponzi scheme takes some of the investors’ money and gives it back to them, every month, seemingly paying a high dividend. People hear about this great investment or some broker tells them about it and the Ponzi scheme suddenly has millions and millions of dollars. The operation of a Ponzi scheme is all about appearances.

The difference between a high yield investment in the private securities market and an investment into a Ponzi scheme is often the honesty of the people who are running the company into which you are investing. Some people will take your money and really try to make their business work. The operator of a Ponzi scheme is a thief.

The promise of consistent high income is common to all Ponzi schemes. High yield is the bait that snares investors and makes Ponzi schemes profitable for the thieves that operate them. Each scheme always comes with a great story about how the company can earn enough money to pay out 12% or 15% or more to investors and still make a profit.

I cannot remember a Ponzi scheme run by someone who was trying to secure cancer treatments for their impoverished parents. When the forensic accountants add up the swag accumulated by most Ponzi scheme operators there are frequently yachts, expensive jewelry and lavish lifestyles all paid for with the investors’ money.

No one is surprised when the brokers who helped to bring investors into the scheme are also found to have been well compensated. I have witnessed a succession of less than honest operators who paid themselves high front-end fees and who lavished golf trips and big parties on the stock brokers and others who would bring trusting investors to their door.

There was one particular Ponzi scheme that was a little different and which I saw played out twice about 10 years apart. In both cases, the high returns were supposedly generated by medical receivables that were purchased at a discount.

In the 1990s a company called Towers Financial raised hundreds of millions of dollars from investors. The funds were intended to purchase medical receivables from smaller, private hospitals. Investors were told that the medical insurance companies were paying slowly and that buying these receivables helped the cash flow of each small hospital.

Towers Financial allegedly bought the receivables at a discount of 8% and claimed to collect the bulk of them in 90 days as opposed to the 30 days that the hospitals needed. This supposedly allowed Towers to roll investors’ money over 4 times per year generating more than a 30% return; more than enough to pay 18% to investors. The operators never actually bought any receivables and used money from newer investors to pay investors in its older funds.

What I especially remember about Towers is that they employed a group of actors who occupied desks in an office one floor below the corporate offices. When a brokerage firm showed up to investigate Towers, the company executives would walk the party down one flight of stairs to the “bull-pen”. Someone would call ahead and the actors would pretend to be hard at work on the telephones making collections. When the group left, everyone hung up their phone and laughed.

Beginning in 2003, a similar scam was repeated under the name of Medical Capital Holdings which also claimed to be buying receivables from smaller hospitals and health-care facilities. Once it allegedly bought the receivables of those companies, interests in the receivables were sold to investors in the form of private Medical Capital Notes.

Medical Capital Holdings issued more than $2.2 billion of Medical Capital Notes to some 20,000 investors across the country. These notes were sold by stockbrokerage firms in almost every state.

By the time the SEC sued Medical Capital for fraud in July 2009 Medical Capital had almost $550 million in phony receivables on its books and had lost over $300 million on various loans that it did make. Meanwhile, the company had collected over $300 million in fees for managing the money-losing loans. The bankruptcy receiver discovered that Medical Capital spent $4.5 million on a 118-foot yacht and another $18 million on an unreleased movie about a Mexican Little League team.

Despite the fact that Medical Capital was essentially a re-do of the Towers Financial fraud of a decade earlier quite a few brokerage firms sold Medical Capital notes without an adequate investigation.  The individuals who organized and ran Medical Capital had previously had serious problems with insurance industry regulators. These problems were not disclosed to potential investors. That fact alone should have been a red flag to any stockbrokerage firm that had actually conducted a reasonable investigation of Medical Capital.

Ponzi schemes do not spend the money that they raise in the way they promise investors. Who keeps track of the money that a company raises and how it is spent? Auditors. Medical Capital and many of these other questionable investments had none.

Medical Capital refused to hire a reputable accounting firm to audit their books. That reason alone should have been enough for any reputable stockbrokerage firm to have refused to offer Medical Capital securities for sale to its customers.  At least one large brokerage firm, Securities America, apparently questioned the fact that Medical Capital was not audited and allowed it brokers to sell the notes anyway.

Auditors play a crucial role in the public securities markets. They make certain that companies publically report specific financial information about their business and their balance sheets. Auditors provide a transparency and a consistency in our evaluation of the firms who are seeking capital.

Audited financial statements are much rarer in the private securities market. That is partly because regulations governing the private sale of securities do not require audited statements for all private offerings. It is also because there is a presumption in the private markets that participants are more sophisticated and that they can fend for themselves.

If you do invest in a private placement, you know that these are almost always considered to be speculative, high risk investments. You can lose all the money you invest and a lot of people do.  If you cannot afford to lose your money, this market is not for you.

Even in the current very low income investment environment there are still listed companies and funds that pay dividends or interest in the 4%-5% range. There are REITS and real estate funds that pay even more. Too much more and you are buying a speculative investment; a lot more than that and there is a good chance that you are getting scammed.

Staying with listed securities that pay market rate dividends or interest is the best way to avoid losing you money in a Ponzi scheme. If you deal with a major brokerage firm there is less of a chance that they will offer one to you and a greater chance that you will be able to recover your losses if they do.



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